Surge Pricing and Fairness

Several people have asked me to comment on the recent New York Times article titled “Why Surge Prices Make Us So Mad: What Springsteen, Home Depot and a Nobel Winner Know.” Here goes.

First, huge congratulations to Richard Thaler for winning the Nobel Prize in Economics for his amazing work in behavioral economics. He certainly deserves it.

In its most simplistic terms, behavioral economics is the study of people systematically making irrational decisions. For example, buyers seem to prefer prices that end in 9, or buyers might drive across town to save $10 on a $50 item, but wouldn’t drive that far to save $10 on a $500 item. This is truly a fascinating topic.

The New York Times article was focused on one aspect: surge pricing. This is when demand exceeds supply and firms increase prices to more closely match supply and demand while making additional profit. Buyers behave irrationally to surge pricing because they don’t see it as fair. This is irrational in the sense that it is not purely a logical decision. If you are rational, the price of something yesterday should not have an impact on your willingness to pay today. (OK, maybe strategically, yes, but unfairness is emotional, not rational.)

Here is my take:

Fairness is always in the mind of the buyer. If a buyer thinks you are unfair, they will punish you.

When people think something is unfair, they will try to punish the perpetrator (or at least not reward them.). For example, before and after hurricane Irma, stores could have increased prices for high-demand products. People still would have paid. However, they also would remember this and probably not frequent that store again. This is punishing the store.

To quote Thaler, our Nobel Laureate, “If you treat people in a way they think is unfair, then it will come back and bite you.”

Companies should think about the lifetime value of a customer. As pointed out in the article, Home Depot was phenomenal both before and after Hurricane Irma. They immediately confirmed that no prices would change (their standard policy) and at the same time mobilized their logistics organization to get 41 semitrucks into Miami as soon as possible after the hurricane. If I lived in Miami, I would show my appreciation by frequenting Home Depot over their competitors for years to come. Heck, I may do that anyway.

Richard Thaler also said, “A good rule of thumb is we shouldn’t impose a set of rules that will create moral outrage, even if that moral outrage seems stupid to economists.” I agree with this 99 percent. Almost all companies should do their best to understand when buyers see their price moves as unfair and avoid them like the plague.

Uber is a great example of an exception. They have spent years educating customers on why surge pricing is not only fair, but adds value. Surge pricing brings out more drivers. It causes supply to increase to meet the demand.

The exception is if you want to take the time (and the arrows) to educate the market. Perceptions of fairness can change. Remember how irate you were when the airlines started charging for checked luggage? Are you over it yet? If not, are you still mad that they started charging for meals on a plane?

By the way, we accept surge pricing in other areas of our life without (too much) complaint. Hotel prices skyrocket on Super Bowl weekend. Airplane prices go up as the plane sells out and there are fewer seats left to sell. Scalpers routinely buy tickets to events at face value and resell them at huge markups. We may not like any of these, but we’ve come to accept them and don’t punish the vendor because of them.

Your takeaway: Think about fairness before making a price move. Recognize a lack of fairness early. If your buyers think your actions are not fair, they may punish you by boycotting your product or company. Either avoid that price move or take the time and energy to educate your market on why it is fair.

One more suggestion for you: Behavioral economics is fun, interesting and results in many suggestions for what we often call the psychological aspects of pricing. However, you have to understand the true value first. Master value-based pricing, then move into the world of psychology.